Duvall & Associates, Inc.
BUSINESS ADVISOR NEWSLETTER
 

Preparing kids' taxes is tricky

- by Alan Duvall 

Published in Dayton Daily News March 19, 2006  

Sigh.  It doesn’t seem that long ago preparing children tax returns was a snap.  Plug in income - calculate tax – seal envelope - done. 

Unfortunately, Congress often makes things more complicated.  So in the guise of closing loopholes, our legislature introduced clever little features wherein parents and kids essentially bargain for tax benefits. 

Take exemptions:  Parents providing over half support can claim exemptions for children under 19 or kid-students under 24.  But if parents claim the exemption, children are denied the exemption benefit on their own return. 

Parents would normally grab the exemption deduction since they reside in a higher tax bracket.  But high-income parents may find exemption benefits phased out, in which case kids save family taxes keeping their exemption. 

Consider income:  To prevent families shifting income to lower-bracket children, Congress enacted a loophole-closing provision.  Investment income in excess of $1,600, paid to children under 14, is essentially taxed at parents’ top tax rates (Form 8615).   

Alternatively, frustrated parents may elect to back-pedal and claim kids’ investment income on parental returns (Form 8814).  Electing parents receive some benefit from the first $1,600 in the child's income, but the excess is taxed at top bracket rates.   

Children with only investment income to report are limited to an $800 federal standard deduction.  However, the standard deduction increases dollar for dollar with the child’s reported earned income up to a maximum $5,000.   

Thus, a child can report up to $8,200 earned income per year ($5,000 standard deduction plus $3,200 exemption) without imposition of federal income taxes.  The next $7,300 income is only subject to a 10% federal rate. 

From this child-parent bracket disparity oozes a rare shelter opportunity for business owners.  Assume a 42% bracket owner pays her child $15,000 annual wages for janitorial and office work.  The child pays only $900 taxes on the income versus the $6,300 payable by the parent if child is not compensated.  The annual family tax savings of $5,400 can fund college or living expenses.  And if the parents’ business is unincorporated, an under-18 child employee need not pay FICA. 

Family tax maneuverings can also maximize tax benefits from educational expenses as parents factor in their comparatively higher brackets versus the impact of high-income benefit phase-outs.  

So sit down with your child and have that fateful tax discussion.

Alan Duvall is a certified public accountant in Dayton.  Contact him at Alan@Duvallcpa.com.